Interest Reserves And Why Lenders Require Them

An interest reserve is a portion of loan proceeds set aside to make interest payments during a period when the property cannot make them. It is standard on construction and heavy renovation lending.

The problem it solves

A property under construction or gutted for renovation has no tenants and no income. The loan still accrues interest from the first draw onward.

Without a reserve, the borrower funds those payments from other resources every month until the property stabilizes, which can be a long stretch on a larger project.

The reserve lets the loan pay itself during that window, which is why these facilities are sized against total project cost rather than current income.

It also gives the lender a form of control, because the money that services the debt sits with the lender rather than depending on the borrower remitting it each month.

How it is sized and drawn

The lender projects the outstanding balance over the construction period, applies the expected rate, and adds a buffer for slower absorption or a delayed schedule.

Payments are then made by drawing from the reserve rather than by transferring funds. Each draw increases the loan balance, which in turn increases the following month's interest.

Because the reserve is part of the loan, the borrower is borrowing to pay interest on borrowings. The balance compounds toward the loan ceiling.

What happens if it runs out

A reserve sized for an on-schedule project depletes early if the schedule slips or if rates on a floating loan rise above the assumption used.

Once exhausted, payments revert to the borrower at exactly the moment the project is behind and cash is tightest. Loan documents often treat depletion as a condition requiring a fresh deposit.

This is why the sizing assumptions matter more than the existence of the reserve. A thin reserve postpones a funding need rather than removing it.

The effect on measured cost

Interest paid from a reserve is still interest. It appears in project cost and reduces proceeds available for construction unless the loan was sized to include it.

A project that looks like it needs less equity because of a reserve has not become cheaper. The cost has moved into the loan balance.

Comparing two loans requires netting the reserve out of both, otherwise the larger loan appears to demand less cash while carrying more debt.

Where to get this checked

Reserve mechanics, draw conditions and replenishment obligations sit in the loan agreement, and they vary substantially between lenders.

An attorney reviewing construction loan documents, and an accountant on the treatment of capitalized interest, are both appropriate before signing anything.